In April 1984, Royal Paper Corporation began discussing a possible sale of its linerboard assets to Atlantic Corporation. By acquiring these assets (Royal Papers Monticello linerboard-mill and 16 corrugated box plants), Atlantic would achieve an important strategic goal of increasing firm-wide linerboard capacity.

Atlantic Corporation

As one of the nations largest forest product/paper firms, Atlantic competed in three businesses: building products, paper and pulp, and chemicals. Two-thirds of its sales and operating profits stemmed from its building products division, which was the worlds largest producer of plywood. Sales and profits of forest products such as plywood are tied to construction activity, which in turn is very sensitive to interest rate fluctuations.

The Market for Linerboard

Linerboard, a stiffened paper product, is primarily transformed into corrugated cardboard boxes, which are used to pack most of U.S. goods shipped. Changes in the level of industrial production are closely tied to box shipments and linerboard sales. Like the building product industry, the linerboard industrys performance is closely tied to the overall economy, but less so. This is mainly because in periods of high interest rates, new home starts can be brought practically to a halt, but industrial production and the packaging of goods in boxes do not stop.

Analysts expected 1984 to be healthy for the linerboard industry. Strong demand, limited supply, and limited new capacity were expected to cause the industry to operate at nearly 100% utilization. Given the high fixed costs in the industry, high operating rates meant high profits. Linerboard and box sales were predicted to rise nearly 7%. Yet, only 1%-2% new capacity was expected before the end of 1986. Linerboard makers would therefore operate at historically high levels of production, with operating rates expected to increase to 99% and linerboard prices to top $420 per ton by the end of 1986.

Atlantic's Interest in Linerboard

Atlantic's intention to add linerboard capacity was well known. The firm's existing Toledo, Ohio linerboard mill produced 780 tons of linerboard per day. This being only 1.8% of domestic capacity, Atlantic could share in only a small way in the expected healthy market. More importantly, Atlantic was the only major paper producer that was a net buyer of linerboard. Atlantic purchased some 150,000 tons of linerboard each year from competitors to feed its box plants. Given the current tight market, linerboard could become available only at very high prices or even unavailable at all. Atlantic's box plants might be forced to turn away orders and the box division's profits could be eroded.

Atlantic had studied possible remedies. A new 2,000-daily-tons linerboard mill would cost $750M, require investing $60M in working capital, and take two years to build. With cash costs and interest rates at historic highs, this was not a valuable proposition. Other firms seemed to reach the same conclusion, as indicated by the lack of new linerboard plants in the industry.

Atlantic then rated (A, B or C) the existing U.S. linerboard mills depending on capacity, age, etc. Unlike business school students, many received a C. None of the owners of A-rated mills (including Royal whose Monticello mill was ranked as the fourth best in the country) were interested in selling. In late 1983, Atlantic bid for Continental Group's package of three linerboard mills, with a combined capacity of over 1.1 million tons per year (or 3,143 daily tons). However, Atlantic lost the bid to Stone Container Corp., whose product line consisted almost exclusively of linerboard and box products. According to Mr. Stone, the three mills were purchased for $112,500 per daily ton, excluding working capital and without assigning any value to the corrugated box plants included in the deal. This represented only about 30% of the cost of building new capacity, which could not be brought in for less than $375,000 per daily ton 2 years later.

The Royal Paper Package: Mill and Box Plants

The Monticello, Mississippi mill. Completed in 1968, the $121M state-of-the-art mill produced both linerboard and kraft paper (used to manufacture grocery bags). In December 1983, Royal announced a modernization plan, which involved spending $70-$80M over 20-22 months to convert the mill's kraft capacity to linerboard capacity. This would increase the mill's linerboard capacity from 661,000 to 747,000 annual tons (or 2,134 daily tons). Part of the output would be transformed into corrugated boxes in the 16 box plants, and the rest by Atlantic's own box plants. As of April 1984, the conversion process had not yet been started.

Corrugated box plants. Due to high shipping costs, box plants tended to be located near end-users. Royal Paper's 16 box plants location (South, Midwest, and East) made them almost ideally suited for a combination with Atlantic's plants (West, South, and Midwest) as together they would cover most major U.S. markets.

Exhibit 1 shows Atlantics forecast for the Monticello mill and the 16 box plants. Capital expenditures of about $140.8M would be incurred to convert the mill's kraft capacity to linerboard capacity, improve the plants' efficiency, and maintain the facilities. The mill and the plants would have a 10-year economic life (through 1993), at which time Atlantic would decide whether or not to maintain the operation by investing in new capacity to replace the mill and plants. No salvage value was expected at the end of their lives. The purchase would include net working capital of about $49M already in place.

Royal Paper Corporation

Over 1974-81, Royal Paper's sales and net profits grew at about 9% each year. However, the industry experienced a downturn in 1982-83. Royal Papers sales and profits fell, and in 1982, its stock price fell to a 15-year low. This downturn was precipitated by a weakening of Royal Paper's major forest product/paper markets and was offset by the stable performance of its printing papers division. In response, Royal Paper cut its workforce by 10% and divested itself of over a dozen money-losing mills.

Although Royal Papers stock had climbed back to the mid-30 dollar range by the end of 1983, its management was still under considerable pressure. In fact, Royal Papers interest in selling linerboard assets to Atlantic seemed linked to its recent dealings with significant shareholders. In February 1984, as Royal was recovering from the industry-wide slump, the Wall Street Journal reported "Royal Paper Seen Likely Takeover Target as Buyer Pays 2-Point Premium for Huge Block of Shares," and identified the buyer as Sir James Goldsmith, a reputed corporate raider. In March, Royal announced it had purchased Goldsmith's stock back from him at a substantial premium. Goldsmith's profit from the greenmail was rumored to be around $50M. Just days after the repurchase, Loews Corp., an insurance, hotel, entertainment, and tobacco company, was announced to have acquired 7.7% of Royal.

Atlantic's Financing

Atlantic thought Royal Paper's CEO was determined to protect the company's independence, and would use the proceeds from the sale to repurchase Loews's stake. But how much were the assets worth? Another issue was financing. The purchase would create financing pressures in addition to those projected for Atlantic without the purchase. With earnings depressed and raiders on the prowl, this was an important issue for Atlantic's management.

Atlantic had been investigating possible financing sources. While the financial markets had been volatile in the late 1970s and early 1980s, the situation in April 1984 was relatively calm. The stock market also seemed poised to move higher on the strength of a recovery in corporate earnings and further declines in interest rates (see Exhibit 2). In this environment, Atlantic could consider the following:

• Drawing on its bank credit line of $200M, which bore interest at the prime rate plus 1-1/2% (current prime rate, 9.25%);
• Issuing up to $400M of 25-year non-callable debentures at a yield of 10-1/4% to be repaid in equal installments over 10 years starting in the sixth year;
• Issuing up to $300M common stock at an estimated price of $30 per share with net proceeds to the company of $28 per share (current stock price, $32);

Atlantic's board of directors was concerned that its debt might slip further within the BBB category. Atlantic already had one of the lowest bond ratings among its major peer group competitors (see Exhibit 3).

Questions

It is essential that you state clearly all the assumptions you are making, and why you make them. Otherwise, grading becomes impossible and you will not get partial credit.

1) Estimate Atlantics valuation for the group of assets

1. Estimate separately each of the components of the relevant WACC for the valuation, and the WACC itself. State explicitly the assumptions you are making, and why you are making them.

To make grading easier, use a 13% WACC for the rest of the case.

2. Estimate separately (i) the relevant Free Cash Flows over the 1984-93 period and their present value, (ii) a terminal value, and (iii) the implied value for the assets. State all your assumptions explicitly.

Exhibit 1: Financial Projections Prepared by Atlantic Corporation Staf for the Monticel and the Box Plants 1984 1985 19406 1987 1998 19:09 199.0 1991 1992 1993 699 747 Monticello la Annual capacity (000 tons) Vization rate Production rate (000 tons) Price per ton M sales (5 millions) Cost of goods sold (5 millions) 661 95% 628 320 200,9 160,3 93% 650 360 234,0 176,1 747 93% 695 400 277,9 194,2 747 95% 710 410 291,0 211,3 747 95% 710 430 315,1 221,5 747 95% 710 452 320,8 232,7 95% 710 475 337.1 244,2 747 95% 710 498 353,4 256,4 747 95% 710 523 371.1 269,2 747 95% 710 549 389,6 282,8 Operating profit before depreciation and taxes 40,6 57,9 83,7 79,7 83,6 88,1 92,9 97,0 101,9 106,8 Box Plats Operating profit before depreciation and taxes 11,6 14,8 16,3 17,1 18,0 18,9 19,8 20,8 21,8 22,9 Combined and Plants Operating profil before depreciation and taxes Depreciation expense 52,2 20,9 72,7 28,3 100,0 35,0 96,8 39,3 101,6 41,3 107,0 39,3 112,7 34,3 117,8 27,1 123,7 26,3 129,7 25,3 ENT Tax @36% EBIT(1-4) 31,3 11,3 20,1 44.4 16,0 28.4 65,0 23,4 41,6 57,5 20,7 36,8 60,3 21,7 38,6 67,7 24,4 43,3 78,4 28,2 50,2 90,7 32,7 58,1 97.4 35,1 62.4 104.4 37,6 66,8 Plant, property & equipment Planned capital expenditures Depreciation 19,2 20,9 30,5 28,3 41,7 35,0 10,2 39,3 10,2 41,3 8,2 39,3 6,2 34,3 6,2 27.1 4,2 26,3 4,2 25,3 Net Property, Plant & Equipment 263,3 270,5 277,2 248,1 217,0 185,9 157,8 136,9 114,8 93.7 Working capital Accounts receivable Inventories Accounts payable 38,0 37.0 17,0 48,0 47,0 21,0 55,0 53,0 24,0 58,0 56,0 25,0 61,0 59,0 27,0 64,0 62,0 28,0 70,0 68,0 31,0 74,0 71,0 32,0 77.0 75,0 34,0 Net working capital 58,0 74,0 84,0 89,0 93,0 98,0 103,0 107,0 113,0 118,0 Exhibit 2 Capital Markets Data US TBS US 30-Year Bond yiekls, as of April 9, 1984 7,53% 8,49% Corporate Bonds AA A AAA B2B Yield 8,73% 8,99% 9,46% 10,05% Debt X total capital Industrials Forest products and paper 18% 30% 25% 32% 40% 40% 38% Historic Market Risk Premium (1926-1984) 8,00% 1983 Exhibit 4. Atlantic Corp., 1979-83. Year Ended, December 31. $rios) 1979 19:00 1981 1982 come statement Net sales 5.207 5.026 5.414 5.402 COGS 4.328 4.269 4.720 4.791 SG&A 279 290 327 377 ET 600 467 367 234 Interest 93 105 137 155 Prut before tax 507 352 20 79 Extraordinary loss 0 0 0 0 Tax 181 119 70 27 Net income 326 243 160 52 6.469 5.653 399 417 140 277 118 54 105 Assets Current assets Net fixed assets Total assets 1.161 2.957 4.118 1.28 3.274 4.512 1.417 3.643 5.060 1.449 3.701 5.150 1.516 3.463 4.979 Librities and Net worth STD AP LTD, current portion LTD Other abities Common equity Total 62 519 75 1.109 382 1.951 4.118 192 520 75 1.227 429 2.069 4.512 257 552 85 1.487 475 2.214 5.060 167 568 95 1.618 480 2.22 5.150 10 627 95 1.523 482 2.242 4.979 * Sales COGS SG&A Cument assets Net Exed assets AP 83,1% 5,4% 22,3% 56,8% 10,4% 84,9% 5,8% 24,6% 65,1% 10,3% 87,2% 6,0% 26,2% 67,3% 10,2% 88.7% 7,0% 26,8% 68,5% 10,5% 87.4% 6,2% 23.4% 53,5% 9,7% Tax as X of profit before tax 36% 33% 30% 34% 19% Exhibit 3 Statistics on Selected Forest Products, Paper and Cherboard Producers Atlantic Corporation 19:00 19:81 Stone Container 19:00 1981 Champion International 19:00 1981 1982 1979 1982 1983 1979 1982 19:03 1979 1983 5.207 5.016 5.414 5.402 328 379 411 427 3.751 3.753 4.0.14 3.737 Sales (5 millions) Linerboard sales (5 millions) Linerboard capacity (000 tons) 6.469 74 273 660 P0 1.295 4.264 251 930 Average stock price ($/share) Book debt (5 millions) 27 1.620 33 381 25 1.120 Net income (5 millions) EPS (share) 105 0,98 22 1,56 1,22 Capitalization at book X debt 37 37 39 61 42 58 48 52 47 53 42 58 45 55 40 60 49 51 51 49 67 33 33 67 36 64 38 62 % common Bond rating Equity beta BOB 1,35 A 1,40 1,15 Union Camp 1980 1981 Interational Paper 19:00 1981 Royal Paper 1980 1981 1979 1982 19:03 1979 1982 19:03 1979 1982 1983 1.389 1.575 1.666 1.526 4.533 5.143 4.983 4.015 2.498 2.713 2.819 2.556 Sales (5 millions) Linerboard sales (5 millions) Linerboard capacity (000 tons) 1.688 362 1.340 4.357 412 1.527 2.775 163 603 Average stock price (share) Book debt (5 millions) 71 718 53 941 30 706 Net income (5 millions) EPS (share) 133 5,45 131 2,46 55 1,40 Capitalization at book X debt % common 30 37 37 20 80 25 75 23 77 38 62 29 71 25 75 21 79 23 77 22 78 31 69 40 60 34 66 Bond rating AA 1.10 ANA 1,15 BOB 1,25 Equity beta Exhibit 1: Financial Projections Prepared by Atlantic Corporation Staf for the Monticel and the Box Plants 1984 1985 19406 1987 1998 19:09 199.0 1991 1992 1993 699 747 Monticello la Annual capacity (000 tons) Vization rate Production rate (000 tons) Price per ton M sales (5 millions) Cost of goods sold (5 millions) 661 95% 628 320 200,9 160,3 93% 650 360 234,0 176,1 747 93% 695 400 277,9 194,2 747 95% 710 410 291,0 211,3 747 95% 710 430 315,1 221,5 747 95% 710 452 320,8 232,7 95% 710 475 337.1 244,2 747 95% 710 498 353,4 256,4 747 95% 710 523 371.1 269,2 747 95% 710 549 389,6 282,8 Operating profit before depreciation and taxes 40,6 57,9 83,7 79,7 83,6 88,1 92,9 97,0 101,9 106,8 Box Plats Operating profit before depreciation and taxes 11,6 14,8 16,3 17,1 18,0 18,9 19,8 20,8 21,8 22,9 Combined and Plants Operating profil before depreciation and taxes Depreciation expense 52,2 20,9 72,7 28,3 100,0 35,0 96,8 39,3 101,6 41,3 107,0 39,3 112,7 34,3 117,8 27,1 123,7 26,3 129,7 25,3 ENT Tax @36% EBIT(1-4) 31,3 11,3 20,1 44.4 16,0 28.4 65,0 23,4 41,6 57,5 20,7 36,8 60,3 21,7 38,6 67,7 24,4 43,3 78,4 28,2 50,2 90,7 32,7 58,1 97.4 35,1 62.4 104.4 37,6 66,8 Plant, property & equipment Planned capital expenditures Depreciation 19,2 20,9 30,5 28,3 41,7 35,0 10,2 39,3 10,2 41,3 8,2 39,3 6,2 34,3 6,2 27.1 4,2 26,3 4,2 25,3 Net Property, Plant & Equipment 263,3 270,5 277,2 248,1 217,0 185,9 157,8 136,9 114,8 93.7 Working capital Accounts receivable Inventories Accounts payable 38,0 37.0 17,0 48,0 47,0 21,0 55,0 53,0 24,0 58,0 56,0 25,0 61,0 59,0 27,0 64,0 62,0 28,0 70,0 68,0 31,0 74,0 71,0 32,0 77.0 75,0 34,0 Net working capital 58,0 74,0 84,0 89,0 93,0 98,0 103,0 107,0 113,0 118,0 Exhibit 2 Capital Markets Data US TBS US 30-Year Bond yiekls, as of April 9, 1984 7,53% 8,49% Corporate Bonds AA A AAA B2B Yield 8,73% 8,99% 9,46% 10,05% Debt X total capital Industrials Forest products and paper 18% 30% 25% 32% 40% 40% 38% Historic Market Risk Premium (1926-1984) 8,00% 1983 Exhibit 4. Atlantic Corp., 1979-83. Year Ended, December 31. $rios) 1979 19:00 1981 1982 come statement Net sales 5.207 5.026 5.414 5.402 COGS 4.328 4.269 4.720 4.791 SG&A 279 290 327 377 ET 600 467 367 234 Interest 93 105 137 155 Prut before tax 507 352 20 79 Extraordinary loss 0 0 0 0 Tax 181 119 70 27 Net income 326 243 160 52 6.469 5.653 399 417 140 277 118 54 105 Assets Current assets Net fixed assets Total assets 1.161 2.957 4.118 1.28 3.274 4.512 1.417 3.643 5.060 1.449 3.701 5.150 1.516 3.463 4.979 Librities and Net worth STD AP LTD, current portion LTD Other abities Common equity Total 62 519 75 1.109 382 1.951 4.118 192 520 75 1.227 429 2.069 4.512 257 552 85 1.487 475 2.214 5.060 167 568 95 1.618 480 2.22 5.150 10 627 95 1.523 482 2.242 4.979 * Sales COGS SG&A Cument assets Net Exed assets AP 83,1% 5,4% 22,3% 56,8% 10,4% 84,9% 5,8% 24,6% 65,1% 10,3% 87,2% 6,0% 26,2% 67,3% 10,2% 88.7% 7,0% 26,8% 68,5% 10,5% 87.4% 6,2% 23.4% 53,5% 9,7% Tax as X of profit before tax 36% 33% 30% 34% 19% Exhibit 3 Statistics on Selected Forest Products, Paper and Cherboard Producers Atlantic Corporation 19:00 19:81 Stone Container 19:00 1981 Champion International 19:00 1981 1982 1979 1982 1983 1979 1982 19:03 1979 1983 5.207 5.016 5.414 5.402 328 379 411 427 3.751 3.753 4.0.14 3.737 Sales (5 millions) Linerboard sales (5 millions) Linerboard capacity (000 tons) 6.469 74 273 660 P0 1.295 4.264 251 930 Average stock price ($/share) Book debt (5 millions) 27 1.620 33 381 25 1.120 Net income (5 millions) EPS (share) 105 0,98 22 1,56 1,22 Capitalization at book X debt 37 37 39 61 42 58 48 52 47 53 42 58 45 55 40 60 49 51 51 49 67 33 33 67 36 64 38 62 % common Bond rating Equity beta BOB 1,35 A 1,40 1,15 Union Camp 1980 1981 Interational Paper 19:00 1981 Royal Paper 1980 1981 1979 1982 19:03 1979 1982 19:03 1979 1982 1983 1.389 1.575 1.666 1.526 4.533 5.143 4.983 4.015 2.498 2.713 2.819 2.556 Sales (5 millions) Linerboard sales (5 millions) Linerboard capacity (000 tons) 1.688 362 1.340 4.357 412 1.527 2.775 163 603 Average stock price (share) Book debt (5 millions) 71 718 53 941 30 706 Net income (5 millions) EPS (share) 133 5,45 131 2,46 55 1,40 Capitalization at book X debt % common 30 37 37 20 80 25 75 23 77 38 62 29 71 25 75 21 79 23 77 22 78 31 69 40 60 34 66 Bond rating AA 1.10 ANA 1,15 BOB 1,25 Equity beta